Market News and Analysis

The pound has borne the brunt of uncertainty over the UK economy following last June’s referendum and as Article is triggered more volatility and uncertainty is expected.

GBPUSD declined rapidly in the wake of the vote before steadying. But October’s flash crash highlighted just how nervous traders are about the pound and the exchange rate has largely failed to recover since then. By Tuesday March 14th sterling was back at 8-week lows, trading a little above $1.21.

So where now for the pound?

Many in the markets think the pound will continue lower, arguing that parity with the US dollar is possible. The bearish case is supported by a number of large banks, with Goldman Sachs arguing sterling is set to be even less fashionable in the coming months. A large current deficit and a drying up of inward investment is a primary factor in thinking the pound will remain weak. And with the prospect of a second referendum on Scottish independence, pressure remains firmly on the pound.

Others, such as Morgan Stanley think that the downside risks firmly priced in already and say the only way is up. The UK has proved remarkably resilient and there it ought to continue to remain strong.

Sterling and the UK economy

Cable is the chief bellwether for market sentiment towards the UK and how the country is prospering. After the June referendum the pound is anchored close to 31-year lows despite the economy doing well. Growth has remained resilient and the price action has been determined more by the politics than the data. That’s made some of the usual assumptions about what drives GBPUSD somewhat redundant. Nevertheless, some key data like inflation remains central to our expectations of the pound’s direction.

What’s driving the value of the pound? In our forthcoming whitepaper on trading around Brexit we look at some of the most important elements:

Trade

Economy

Inflation & Interest Rates

In this post we will look at how trade relationships and expectations for a deal affect the value of sterling.

Trade

You can’t go very far talking about Brexit without the thorny issue of trade creeping in. At the heart of the exit process will be how Britain extricates itself from the single market and renegotiates trade terms with the EU. Tariffs would make British goods more expensive, therefore sterling has to weaken to balance this out. But there are also non-tariff barriers, such as customs checks, that could make the cost of doing business more. To remain competitive the pound has to be lower.

The terms of Britain’s trade with the EU will also matter for trade with other nations. Britain says it wants to strike bilateral trade deals with non-EU countries but it cannot do that unless it leaves not only the single market but the looser customs union. Leaving the customs union without a new trade deal with the EU in place would see the UK default to WTO terms. This could require a weaker pound.

Britain has been running a current account deficit for years and this has been financed by foreign capital – the ‘kindness of strangers’ that some describe. Markets expect Brexit to cause this flow to dry up, meaning the pound has to weaken to redress the imbalance.

It is also a recalibration based on the attractiveness of the UK as an investment location. The pound has had to fall in order to make UK assets attractive. If Britain does have to go beyond Europe for investment then the pound might have further to fall. Leaving the single market will depress investment.

Some economists, like Ashoka Mody, point out that the pound was artificially stronger before the referendum because of hot flows of capital into London's booming property market. The link between London's property market and its status as a global financial hub is crucial - therefore the deal for the City will matter for the pound.

London has pulled in financial services activity and capital thanks to the economies of scale found in the City. But Brexit changes this.

Given that trade terms are likely to be worse than they are at present, Britain now faces the prospect of much higher transaction costs when doing business with the rest of Europe, which Paul Krugman notes “creates an incentive to move those services away from the smaller economy (Britain) and into the larger (Europe). Britain therefore needs a weaker currency to offset this adverse impact”. This is based on a simple economic model that states not all production (financial services in this case) will relocate to the large economy (the EU) as the small economy (UK ) is able make up for its lack of competitiveness by having a weaker currency.

The point is that the City is no longer located in the larger market, diminishing the flows of capital into the UK and therefore demand for sterling as businesses relocate to where it is cheaper to transact.

The relationship of the UK property market and hot flows of capital to the sterling exchange rate is also important.

Since 2012 a property bubble in London drove an appreciation in sterling and a widening of the current account deficit. Double-digit rises in property prices pushed up the exchange rate and pound effectively became overvalued.

Brexit ended this trend and we have seen London prices cool markedly. Outflows from property funds surged in the wake of the referendum, forcing many to shutter to new withdrawals to prevent collapse.

Viewed through both of these examples, we can see that Britain was experiencing hot flows of cash into London (thanks to the City’s status) which drove up property prices and the value of sterling. Rising property values (seen as a safe haven for investors, again because of London’s pre-eminence as a global financial hub) fuelled further capital inflows in a version of the carry trade.

One of the most important considerations for valuing the pound is therefore the outcome for financial services from Brexit. Will the banks leave? Will London lose its status as Europe’s most important financial centre? The other – of course related – is the path of London property prices as a guide to sterling demand.

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